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© Prentice Hall, 2000
1
Chapter 9
The Art and Science of Estimating Project Cash Flows
Shapiro and Balbirer: Modern Corporate Finance:
A Multidisciplinary Approach to Value Creation
Graphics by Peeradej Supmonchai
© Prentice Hall, 2000
2
Learning Objectives
Explain the importance of using incremental reasoning in identifying a project’s cash flows.
Identify a project’s initial investment, incremental operating cash flows, and terminal value and use these estimates to calculate the project’s NPV.
Describe how the failure to deal with inflation and other biases in capital budgeting can lead to inappropriate investment decisions.
Discuss the importance of properly assessing the effects of product line cannibalization in a new product introduction.
Use the principle of purchasing power parity to properly evaluate an overseas project.
© Prentice Hall, 2000
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Learning Objectives (Cont.)
Describe how the failure to identify managerial options can systematically undervalue an investment project
Explain the importance of creating barriers to entry by potential competitors is important to the generation of positive NPV projects.
Indicate how an option valuation approach can be used to evaluate R&D projects.
Describe how techniques such as sensitivity analysis, simulation, and decision trees can help managers to understand the sources of project risk.
© Prentice Hall, 2000
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Guidelines for Estimating Project Cash Flows
Apply incremental reasoning
Ignore fictional accounting flows
Be careful about transfer prices
Ignore sunk costs
Don’t ignore opportunity costs
Don’t forget working capital requirements
Don’t forget abandonment costs or terminal value
© Prentice Hall, 2000
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Incremental Cash Flows for a Project
Initial investment
Operating cash flows
Terminal or salvage values
Abandonment costs
© Prentice Hall, 2000
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Initial Investment
A project’s initial investment may consist of three
components:
Cost of acquiring and placing the asset in service
Net proceeds from the sale of the existing equipment
Tax consequences of selling an existing asset
© Prentice Hall, 2000
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Operating Cash Flows
The incremental operating cash flows (OCF), per period, can be expressed as
OCF = ( REV - COST - DEP)(1 - TAX) + DEP - WC
Where:
REV = the change in revenues
COST = the change in operating costs
DEP = the change in depreciation
WC = the annual increase in working capital
TAX = the marginal tax rate faced by the firm
© Prentice Hall, 2000
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Terminal or Salvage Values
A project’s terminal, or salvage value may consist
of one or more of the following elements:
Salvage value of equipment
Recovery of working capital
Cash flows beyond some initial evaluation period
© Prentice Hall, 2000
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Abandonment Costs
Some projects require cash outflows when
the project is terminated. For instance, firms
in certain industries may have to incur high
costs to meet environmental standards.
© Prentice Hall, 2000
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The Replacement Problem
A class of investments where a company
is looking to replace an existing piece of
equipment with a new “model.”
The motivation for these projects is either
cost reduction or quality improvement or
both.
© Prentice Hall, 2000
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Spectrum Manufacturing Company
Existing Equipment
Cost = $120,000 Depreciation = $12,000/Year Book Value = $60,000
Salvage Value Today = 10,000 Salvage Value in 5 Years = $0
New Equipment
Cost = $100,000 Depreciation = $20,000/Year
Cash Savings = $24,000/Year Salvage Value in 5 Years = $0
© Prentice Hall, 2000
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Spectrum Manufacturing Company- Initial Investment
Installed Cost of Computerized Lathe $100,000
Salvage Value of Old Lathe 10,000
Tax Effects from Selling Old Lathe 20,000
INITIAL INVESTMENT $70,000
© Prentice Hall, 2000
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Spectrum Manufacturing Company - Operating Cash Flows
Year 1 Year 2 Year 3 Year 4 Year 5
Annual Cash Savings $24,000 $24,000 $24,000 $24,000 $24,000
Depreciation (8,000) (8,000) (8,000) (8,000) (8,000)
Taxable Income $16,000 $16,000 $16,000 $16,000 $16,000
Taxes@40% (6,400) (6,400) (6,400) (6,400) (6,400)
After-Tax Income $ 9,600 $9,600 $ 9,600 $9,600 $9,600
Plus: Depreciation 8,000 8,000 8,000 8,000 8,000
Annual OCF $17,600 $17,600 $17,600 $17,600 $17,600
© Prentice Hall, 2000
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Spectrum Manufacturing Company- The Project’s NPV
NPV = $17,600 [PVIFA 5,10] -$70,000
= $17,600(3.7908) - 70,000
= -$3,282
© Prentice Hall, 2000
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Inflation Biases in Capital Budgeting
Required returns in the financial markets
embody inflationary expectations. Not
adjusting cash flows for inflation means that
firms will be discounting real cash flows by
nominal interest rates. This systematically
understates a project’s NPV.
© Prentice Hall, 2000
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Inflation Biases- An ExampleYear 1 Year 2 Year 3 Year 4 Year 5
Annual Cash Savings $24,000 $24,960 $25,958 $26,997 $28,077
Depreciation (8,000) (8,000) (8,000) (8,000) (8,000)
Taxable Income $16,000 $16,960 $17,958 $18,997 $20,077
Taxes@40% (6,400) (6,784) (7,183) (7,599) (8,031)
After-Tax Income $ 9,600 $10,176 $11,775 $11,398 $12,046
Plus: Depreciation 8,000 8,000 8,000 8,000 8,000
Annual OCF $17,600 $18,176 $18,775 $19,398 $20,046
Present Value $16,000 $15,021 $14,106 $13,249 $12,447
NPV = $70,824 $70,000 = $824
© Prentice Hall, 2000
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Biases in Capital Budgeting
Inflation
Projects with overestimated cash flows are
more likely to be chosen
Manager overoptimism
Manager pessimism
© Prentice Hall, 2000
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New Product Introduction
Investments related to (1) product or service
extensions, or (2) product innovations. The
estimates of cash flows from new product
introductions are subject to a far greater
degree of uncertainty than are replacement
projects
© Prentice Hall, 2000
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New Product Introduction - Smith Corporation
NEW PRODUCT FINANCIAL FORECASTS
( ALL FIGURES IN $1,000)
Period 0 1 2 3 4 5 6
Sales 500 5,500 8,000 14,000 7,000 4,000
Operating Expenses 800 3,410 4,960 8,680 4,340 2,480
Product Promotion 3,000 1,000
Depreciation 1,000 1,000 1,000 1,000 1,000 1,000
Profit Before Taxes 3,000 2,300 1,090 2,040 4,320 1.660 520
Taxes @ 34% 1,020 782 371 694 1,469 564 177
Profit After Taxes 1,980 1,518 719 1,346 2,851 1,096 343
Level of Working Capital 250 660 960 1,680 840 480
© Prentice Hall, 2000
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New Product Introduction - Smith Corporation
CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT
+
YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20%
0 $6,000 $1,980 $7,980 $1,980
1 518 250 768 640
2 1,719 410 1,309 909
3 2,346 300 2,046 1,184
4 3,851 720 3,131 1,510
5 2,096 840 2,936 1,180
6 1,343 360 1,703 570
7 $ 660 480 1,140 318
NPV = $2,948
© Prentice Hall, 2000
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Post-Evaluation Period Cash Flow Estimation
The following equation can be used to estimate the cash flows beyond some initial evaluation period:
CFn+1
TVn = ——— (k-g)
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Smith and CompanyNEW PRODUCT #2 FINANCIAL FORECASTS
( ALL FIGURES IN $1,000)
Period 0 1 2 3 4 5 6
Sales 2,500 10,000 16,500 21,000 23,000 25,000
Operating Expenses 1,625 6,500 10,725 13,650 14,950 16,250
S&A Expenses 3,000 3,000 3,000 3,000 3,000 3,000 3,000
Depreciation 750 750 750 750 -0- -0-
Profit Before Taxes 3,000 2,875 250 2,025 3,600 5,050 5,750
Taxes @ 34% 1,020 978 -85 688 1,224 1,717 1,955
Profit After Taxes 1,980 1,898 -165 1,337 2,376 3,333 3,795
Level of Working Capital 750 3,000 4,950 6,300 6,900 7,500
© Prentice Hall, 2000
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Smith and Company
CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT
+
YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20%
0 $3,000 $1,980 $4,980 $4,980
1 1,148 750 1,898 1,531
2 585 2,250 1,665 1,083
3 2,087 1,950 137 72
4 3,126 1,350 1,776 751
5 3,333 600 2,733 932
6 3,795 600 3,195 879
NPV = $4,960
© Prentice Hall, 2000
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Smith and Company- Sensitivity Analysis
(ALL FIGURES IN $1,000)
GROWTH TERMINAL PRESENT VALUE OFRATE % VALUE TERMINAL VALUE PROJECT NPV
3 $15,671 $4,311 $ 648
4 16,614 $4,570 389
5 17,656 4,857 102
6 18,815 5,176 217
7 20,110 5,532 573
© Prentice Hall, 2000
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Product Line Cannibalization
A phenomenon where a new product takes sales away from one or more of a firm’s existing products. Evaluating cannibalization involves the following considerations:
What matters is the incremental effect of cannibalization; the sales lost that can be solely attributable to the new product introduction
Be sensitive to the competitive environment; it is always better to lose volume to your own entry than to one of your competitor’s
© Prentice Hall, 2000
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Evaluation of Foreign Projects - ACS Enterprises
ASSUMPTIONS:
Zero Inflation Environment
Exchange Rate : 1 puff/dollar
YEARS
0 1 2 3 4 5 6
Sales 200 200 200 200 200 0
Net Working Capital 30 30 30 30 30 0
Depreciation Expense 40 40 40 40 40 0
Profit After Taxes 20 20 20 20 20 0
Cash Flow Analysis
Investment in Equipment (200) 0 0 0 0 0 0
Investment in Working Capital 0 (30) 0 0 0 0 30
Cash Flow From Operations 0 60 60 60 60 60 0
Period Cash Flows (200) 30 60 60 60 60 30
Internal Rate of Return = 12.8%
© Prentice Hall, 2000
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Evaluation of Foreign Projects - Purchasing Power Parity
e1 1 + ih = eo 1 + if
Where:
ih = price level increases (rates of inflation) for the home country
if = price level increases (rates of inflation) for the foreign country
eo = the current dollar value of one unit of the foreign currency
e1 = the end-of-period exchange rate.
© Prentice Hall, 2000
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Evaluation of Foreign Projects- ACS EnterprisesASSUMPTIONS:10 percent Annual Inflation
Exchange Rate : Puff Declines by 10% a Year Against Dollar
YEARS 0 1 2 3 4 5 6Sales 200 220 242 266 292 0Net Working Capital 30 33 36 40 44 0Depreciation Expense 40 40 40 40 40 0Profit After Taxes 20 24 28 33 39 0
Cash Flow AnalysisInvestment in Equipment (200) 0 0 0 0 0 0 Investment in Working Capital 0 (30) (3) (3) (4) (4) 44 Cash Flow From Operations 0 60 64 68 73 79 0Period Cash Flows ( in puffs) (200) 30 61 65 69 75 44Period Cash Flows ( in dollars) (200) 27 50 49 47 47 25
Internal Rate of Return ( in puffs) = 16.9% Internal Rate of Return ( in dollars ) = 6.2%
© Prentice Hall, 2000
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Managerial Options and Capital Budgeting
DCF techniques assume that a project’s
cash flows cannot be changed once the
decision to go ahead is made. This is
unrealistic for many projects since
management actions can alter the initial
cash flow estimates after implementation.
Such managerial discretions are options.
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Strategic Options- Bubbly Beverage
SUMMARY OF CASH FLOWS FOR DELIGHTFULLY DELICIOUS LINE
(ALL FIGURES IN $MILLION)
YEAR 1998 1999 2000 2001 2002
After-Tax Operating Cash Flow 140 120 50 100 100
Capital Investment 80 - - - -
Working Capital Changes 20 30 30 20 -
Terminal Value - - - - 500
Net Cash Flow 240 150 20 80 600
NPV @ 20 percent = $15.5 Million
© Prentice Hall, 2000
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Strategic Options- Bubbly Beverage
Traditional capital budgeting analysis
ignores the potential for:
Add-on products
Vertical integration
Related diversification
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Value of Projects With Strategic Options
VPROJ = VDCF + VSTRAT
Where:
VDCF = the project’s value using traditional DCF techniques
VSTRAT = the value of the strategic options
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Sources of Positive NPV Projects
Projects that create economies of scale or scope
Projects that create cost advantage
Projects that allow firms to differentiate products or services
Projects that build or enhance channels of distribution
Government policy